How to assess your working capital requirement (WCR)?

For growing businesses with limited resources, understanding and managing your working capital requirement is essential for ensuring the financial health and stability of your company.

After all, nobody wants to pay their employees or suppliers late. On the flip side, business owners generally don’t want to hold too much inventory or offer overly generous credit terms to customers when they could be investing extra funds in new product lines, marketing, or other growth opportunities.

Knowing your working capital requirement is the key to balancing your short-term assets and liabilities. Read on as we dive into what it is, why it’s important, and how to calculate yours.

What is the working capital requirement (WCR)?

Working capital requirement (WCR) is a financial metric that calculates the amount of funds a business needs to cover its short-term operating expenses, including production cycle costs and repayments of debt.

Unlike working capital, which evaluates the overall liquidity of a business by subtracting current liabilities from its current assets, WCR zooms in on a business’s ability to meet immediate obligations and maintain day-to-day activities.

Businesses need to closely monitor their WCR to:

• Ensure liquidity: Can your business pay its bills, suppliers, and employees on time to avoid disruptions to your operations?
• Optimize working capital: Knowing your working capital requirement helps identify inefficiencies in managing your current assets and liabilities. This can help reduce excess inventory, negotiate better payment terms with suppliers, and improve your accounts receivable management.
• Anticipate financial needs: Tracking your working capital requirement allows you to anticipate your short-term financial needs, particularly when you may need additional funding to cover seasonal fluctuations.

How to calculate the working capital requirement (WCR)?

While different businesses may calculate their working capital requirement (WCR) differently, this is the most common formula:

Working capital requirement (WCR) = (accounts receivable + inventory) - accounts payable

Here’s a breakdown of each component:

• Accounts receivable refers to the money that customers or clients owe your business for goods sold or services. In other words, it represents the outstanding invoices you expect to collect within a specific period, typically 30 to 90 days.
• Inventory includes all the finished goods, raw materials, and work-in-progress products that your company holds for production or sales.
• Accounts payable is the money your company owes to your suppliers for goods and services that you haven’t paid for yet – think of it as the opposite of accounts receivable.

Say a retail store has $90,000 in accounts receivable, $55,000 in inventory, and $25,000 in accounts payable (including $15,000 in inventory purchases and $10,000 in rent and salaries). Using the formula above, its WCR would be $120,000.

Interpreting the working capital requirement (WCR)

Now that you’re familiar with the formulas, it’s time to assess your working capital requirement.

Interpreting the WCR involves understanding its value, whether positive, zero, or negative:

• A positive WCR indicates that your business may be managing its working capital efficiency – it has sufficient liquid resources to cover its current liabilities.
• A zero WCR means that your business’s current assets equal its current liabilities. Because your business has little room for error or unexpected changes in cash flow, you may need to manage your working capital carefully to avoid any disruptions in meeting short-term obligations.
• A negative WCR occurs when your company does not have the resources to cover its current liabilities. While this might initially seem concerning, a negative WCR can sometimes be a deliberate strategy for businesses with strong cash flow cycles (e.g., if you pay suppliers before collecting payments from customers). That said, sustaining a negative WCR in the long term can be risky and may lead to financial difficulties if cash flow patterns change.

How to calculate the working capital requirement for new businesses?

For new businesses that aren’t completely sure of their current assets and liabilities, it can be tricky to calculate their working capital requirement.

Here are some ideas on how new businesses can calculate their WCR:

• Use industry benchmarks: Researching benchmarks for similar businesses in your industry can give you a rough estimate for calculating your WCR.
• Make conservative assumptions: When you don’t have historical financial data to work from, consider erring on the side of caution and make conservative assumptions about future cash inflows and outflows.
• Seek professional assistance: Financial experts or accountants with experience working with new businesses in your industry can provide insights into industry norms.
• Leverage software: Accounting or financial management software may help you better generate financial reports, manage accounts receivable and accounts payable, and track cash flow – ultimately helping you better understand your current assets and liabilities.

As your business gains traction, make sure to review your financial data regularly, including your cost of goods sold and break-even analysis — this can provide a better picture of the company's financial health and help you calculate a more accurate working capital requirement.